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Could too much leverage bring down the system?

Is there systemic risk in private credit? And, if so, what are the chances of it spilling over into the broader economy?

The market has been abuzz with that topic ever since Moody’s Investors Service issued a report warning that “the mounting tide of leverage” sweeping into private credit’s “less-regulated ‘grey zone’ has systemic risks”, writes Robin Blumenthal. The report also cautioned that the growth of private equity and related financing vehicles is concentrating an increasing amount of economic activity among a small number of very large asset managers, thereby “exposing the broader economy to their governance and risk management”.

The Financial Times led an edition with the head “Moody’s warns of ‘systemic risks’ in private credit industry”. Mark Wasden, one of the authors of the Moody’s report, says “the expansion of leveraged lending in a less transparent market is the basis for systemic considerations”. He adds that the lack of market transparency means it might take longer to identify risks and measure them, and that “it might be too late” to regulate and manage these risks.

Still, some regard the concerns as overblown. “Systemic risk has a connotation that the whole financial system can unravel when things go wrong,” says one private credit manager who requested anonymity. “That is fundamentally not true.” That’s because none of the vehicles are taking customer deposits, so there’s no risk akin to a run on a bank. And “no one is running businesses with an asset/liability mismatch”.

But given that the private credit market has ballooned to more than $1 trillion since the financial crisis, and that it is fast approaching the $1.3 trillion institutional loan market, some of the issues raised in the report are not necessarily misplaced.

Increased competition

The report said increased competition in all credit markets has lowered the required standards for borrowers and created incentives to ease credit protections for investors in loan documentation. It attributed the decline in leveraged finance credit quality to the “aggressive financial policies of PE sponsors”, noting that about 65-70 percent of issuers rated B3 negative or below (ie, distressed borrowers) are owned by PE sponsors. The report, citing the latest Shared National Credit publication from the US Office of the Comptroller of the Currency, went on to say that this is mirrored in non-bank lending, which it said holds a disproportionate share of all loan commitments rated below a supervisory pass.

Moody’s noted that its recent study of the top 12 PE rated portfolios found that all were comprised of borrowers that maintain average debt-to-EBITDA levels of more than 6x – much higher than bank loan portfolios and above US Federal Reserve guidance.

Although private credit managers say leverage has increased by between a half and a full turn since March 2020, top managers in the PDI 100 noted that the strong economy and cost-cutting during covid has been mitigating risks, and that earnings are increasing.

“Systemic risk has a connotation that the whole financial system can unravel when things go wrong. That is fundamentally not true”

Anonymous private credit manager

The Moody’s report acknowledged that asset managers’ “financial and managerial sophistication” helps balance the operating and financial risks of small enterprises in direct lending. However, it raised concerns about the increasing downside risk of rising leverage when economic conditions weaken. David Conrod, chief executive of FocusPoint Private Capital, a private fund placement business, raised some of those concerns recently. He noted that US leveraged loan defaults have shot up to about $70 billion in 2021, from around $45 billion in 2020 and less than $20 billion in 2019.

He also said that in cases where covid forced companies to borrow heavily, leverage is likely to be much higher than the 6x average quoted by Moody’s. Moreover, Conrod noted that opportunities in the coming period might be in the lower end of the market, where companies might have more difficulty accessing financing. He also predicted that “fragile credit capabilities will intensify a surge in defaults in 2022 and 2023”. Only time will tell.